Tuesday, December 13, 2011

Which Graph Best Summarizes the Eurozone Crisis?

Niklas Blanchard sends us to the BBC where "top economists" are sharing their most important economic graphs of the year. Here, for example, is an interesting graph from Vicky Price of FTI Consulting:

Price explains its importance:

"For a long time the perception was that the creation of the euro meant sovereign risk was effectively the same across all countries. That of course proved to be wrong. The Lehman's crisis and financial meltdown that followed affected the deficits and debt levels of different countries in different ways. Interestingly it is much the same countries now with very high yields as it was pre-euro, suggesting little has changed fundamentally in a decade."

I agree that long-term interest rates should not have converged across all sovereign debt in the Eurozone, but I also believe that the huge spreads that have now emerged are more than risk premiums simply returning to their normal levels. Rather, they are the result of effectively tight monetary policy that has caused public finances to worsen and that, in turn, is driving the sharp rise in spreads. Nicklas Blanchard agrees and notes that one graph conspicuously absent from the BBC feature is the one that shows the all-important deviation of actual nominal income from its expected path. That graph shows the main story behind the crisis.

This has fundamentally to do with the ECB and Germans' deeply ingrained cultural reluctance to let the ECB embark on the sweeping sovereign bond purchases from Club-Med that is necessary to bring yields back to a sustainable level. I don't think Euro-bonds will ever happen, but it still would not surprise if eventually the Germans gave in a bit on the bond-buying. We shall see...